CFS congratulates Robert Aliber of the University of Chicago on the release of the seventh edition of Manias, Panics, and Crashes. Professor Joseph P. Joyce of Wellesley College wrote a blog post about this release, in which he chronicles the history of the book, from the 1978 first edition by Charles Kindleburger to the 2015 update by Aliber. Joyce explains the continuing popularity and relevance of this book and how its successive authors adapted to changing times.

CFTC Chair Timothy Massad criticized the failure of the 2016 budget agreement to provide “even a small increase” for the CFTC’s “critical work” in a market with a budget of $1.1 trillion.

Chair Massad asserted that “[t]he failure to provide the CFTC even a modest increase in the fiscal year 2016 budget agreement sends a clear message that meaningful oversight of the derivatives markets, and the very types of products that exacerbated the global financial crisis, is not a priority.”

Lofchie Comment: It is difficult not to feel sympathy for Chair Massad. It is a tough budgetary situation. Considering the CFTC’s enhanced responsibilities, the expansive rulemaking that has taken place over the last several years and the seeming lack of regard for the costs of implementing those rules, a zero budget increase is a serious problem.

The CFTC should consider scaling back on regulatory requirements that serve no material purpose. A good place to start is CFTC’s double regulation of SEC-registered investment companies that use CFTC-regulated instruments. Given the acknowledged risks created by central clearing and the absence of systemic risk benefits provided by mandatory exchange trading, the CFTC should hit the brakes on mandatory expansion and allow the market to determine whether these market structure changes actually are useful. Even though Chair Massad cannot control his revenue, he still can control his expenses, and he should pare them down as necessary to meet areas of genuine priority.

The Basel Committee on Banking Supervision proposed a conceptual framework with the objective of mitigating “spillover effects” from the shadow banking system to banks. For the purposes of the consultative document, step-in risk refers to the risk that a bank will provide financial support to an entity beyond or in the absence of its contractual obligations, should the entity experience financial stress. The proposals would form the basis of an approach for identifying, assessing and addressing step-in risk potentially embedded in banks’ relationships with shadow banking entities.

According to the report, the committee will conduct a Quantitative Impact Study and welcomes public comment on the proposals by March 17, 2016. The publication is part of the G20 initiative “to strengthen the oversight and regulation of the shadow banking system and mitigate the associated potential systemic risks.”

Lofchie Comment: This is actually a report that poses good questions. It is not a generalized attack on non-banks that raise money or lend it. Rather, it is a discussion of the relationship between banks and non-bank entities with which the banks have some affiliation, such as sponsored money market funds or conduit financing vehicles.

Ike Brannon – from Capital Policy Analytics – wrote a review for the Weekly Standard of the recent CFS publication Wall Street, the Federal Reserve and Stock Market Speculation: A Retrospective by Elmus Wicker.

Steve Hanke, Johns Hopkins Professor of Applied Economics and a CFS Special Counselor, discusses the Federal Reserve’s announcement of the first interest rate increase in ten years.

Professor Hanke emphasizes the relative importance of the broad money supply, which includes that supplied by the private banking system, as measured by the CFS Divisia report of December 16, 2015. CFS Divisia M4 grew by 4.6% in November 2015 on a year-over-year basis versus 3.4% in October or 2.1% for 2014, a statistic Hanke cited as indicating a “healthy” but “modest” economic growth.

Today we release CFS monetary and financial measures for November 2015.

CFS Divisia M4, which is the broadest and most important measure of money, demonstrated the largest increase since May 2013. CFS Divisia M4 grew by 4.6% in November 2015 on a year-over-year basis versus 3.4% in October or 2.1% for 2014.

The advance in the money supply is in part due to a recovery in the banking sector. Commercial banks’ savings deposits contributed 2.5% to the November increase; whereas demand deposits contributed an additional 0.7%.

FINRA found that liquidity in the U.S. corporate-bond market is healthy “by most measures.” FINRA’s Research Note analyzed all Trade Reporting and Compliance Engine (“TRACE”) transactions from 2003 to September 2015.

FINRA’s research found that:

Most measures indicate a healthy market: new bond issuance is at a “record level,” transaction volumes have continued to grow and the number of trades is rising. The cost of trading corporate bonds has been decreasing, as indicated by narrower bid-ask spreads and falling price impact to block trades.

However, several measures offer evidence of potentially significant changes in how the market is working, including smaller average trade size and a declining proportion of bonds traded in blocks of $5 million or more. “These trends are consistent with a market that has a larger number of issues, more electronic trading and a growing network of counterparties.”

Lofchie Comment: The numbers presented in the FINRA report send considerably more mixed or ambiguous signals than the tone of the report would suggest. The report certainly has some positive numbers in it, but a closer look at those numbers, when viewed in context, may present a different picture. Take, for example, the finding that bid/ask spreads had declined, which seems to be a healthy indicator for the market. The estimated bid/ask spreads are analyzed in the study without regard to average trade size. But as the average trade size has declined substantially, one would expect the bid/ask spread to decline as well. It is not obvious that the bid/ask spread has declined more than one would expect from the correlating decline in the trade size.

The main not so positive number reported is to the effect that turnover in bonds is slower, with the result that it takes longer to trade out of a position. On its face, this negative fact seems inconsistent with the decline in the bid/ask spread. If the bid/ask spread is down, shouldn’t it be easier/quicker to get out of positions? Likewise, the decline in volume seems inconsistent with the fact that short-term electronic traders now play a much larger role in the bond markets. Given that one could expect these traders to accumulate higher volume, as they do not hold positions for an extended period, one would think that trading volume should have risen materially, not declined. In summary, a decline in bid/ask spreads could not be considered such good news to the extent that it is combined with a decline in trade size; and a decline in trade volume is somewhat more negative news if that volume was increased by short-term electronic traders who may be expected to pump volume up.

The report also declared that it was a positive sign for the workings of the bond markets that the amount of new issuance was high. However, as the study points out, the cost of borrowing is relatively close to zero, so one would expect new issuances to be high. It is not obvious why that should be viewed as a positive sign for how well the bond trading markets function.

None of the above is meant to say that the numbers in the report tell an inherently or completely negative story; only that they and their relationships seem to send considerably more mixed or ambiguous signals than the report suggests.

Update: The Wall Street Journal of Dec. 14, 2015, has a story titled “Junk Bonds Stagger as Funds Flee.” The story reports 10% spreads between bids and offers, a stark contrast to the findings and tone of the report.

In a 3-to-1 vote, the SEC proposed a new rule that would restrict the use of derivatives by registered investment companies, including mutual funds, exchange-traded funds and closed-end funds as well as business development companies that are subject to Investment Company Act Section 18 (“Capital Structure of Investment Companies”).

In support of the proposal, SEC Chair Mary Jo White said that funds use derivatives extensively for a variety of purposes, which can raise risks relating to leverage and the fund’s ability to meet future obligations. She remarked on the current practice of mark-to-market segregation, raising concerns that a fund may not have sufficient liquid assets to cover potential future losses. Chair White highlighted three elements that addressed these concerns: 1) new requirements that funds segregate assets to cover their mark-to-market liability, plus an additional risk-based coverage amount designed to address potential future losses on derivatives; 2) portfolio limitations based either on a fund’s aggregate derivatives exposure or on a risk-based analysis; and 3) the requirement that certain funds establish formalized risk management programs.

In presenting the proposal, SEC staff highlighted the following requirements for derivatives:

Portfolio Limitations for Derivatives Transactions: A fund would be required to comply with one of two alternative portfolio limitations (“Exposure-Based Portfolio Limit” or “Risk-Based Portfolio Limit”) designed to limit the amount of leverage the fund may obtain through derivatives and certain other transactions. Under the exposure-based limitation, a fund would be required to limit its aggregate notional derivatives exposure to 150% of the fund’s assets. As an alternative, the risk-based limitation permits a fund to have aggregate notional derivatives exposure of up to 300% of the fund’s assets but only if the fund’s portfolio is subject to less market risk determined by a value-at-risk test.

Asset Segregation for Derivatives Transactions: A fund would be required to manage the risks associated with derivatives by segregating certain assets (generally cash and cash equivalents) equal to the sum of “market-to-market coverage amount” and a “risk-based coverage amount.”A fund would be required to segregate respectively:

(i) assets equal to the amount that the fund would pay if the fund exited the transaction at the time of the determination; and

(ii) an additional risk-based coverage amount representing a reasonable estimate of the potential amount the fund would pay if the fund exited the transaction under stressed conditions.

Derivatives Risk Management Program: Funds that engage in more than limited derivatives transactions or use complex derivatives would be required to establish a formalized derivatives risk management program consisting of certain components administered by a designated derivatives risk manager.

Requirements for Financial Commitment Transactions: A fund that enters into financial commitment transactions would be required to segregate assets with a value equal to the full amount of cash or other assets that the fund is conditionally or unconditionally obligated to pay or deliver under those transactions.

Disclosure and Reporting: Two forms the SEC proposed in May 2015, Form N-PORT and Form N-CEN, would be amended respectively: (i) require a fund that is required to have a derivatives risk management program to disclose additional risk metrics related to a fund’s use of certain derivatives; and (ii) require that a fund disclose whether it relied on the proposed rule during the reporting period and the particular portfolio limitation applicable to the fund.

The majority of Commissioners relied on the white paper for evidence of the necessity for new regulation. They also referenced Section 1(b) of the Investment Company Act (which cites the Policy of the Investment Company Act) as evidence of the statutory need to eliminate undue leverage by registered funds.

Commissioner Aguilar supported the proposal but questioned whether the proposed rules place too large of a burden on fund boards. However, the Commissioner concluded that boards must be proactive in foreseeing the challenges in executing all of their fiduciary and regulatory responsibilities.

Commissioner Piwowar supported the asset segregation requirements but dissented from the portfolio limitations. He reasoned that asset segregation should be enough to address current derivative risks, therefore, absent data indicating that a separate specified leverage limit is warranted there is no justification for imposing any additional requirements or burdens on funds. In addition, the Commission has recently adopted other proposed rules that will either have a direct impact on the risks of derivatives positions held by funds, or will provide us with data that could be used to better understand how we should regulate.

Lofchie Comment: Commissioner Piwowar’s dissent from the proposal of the rule is well-reasoned. The SEC does not have adequate information needed for proper analysis of the proposal at the current time.

As the Commissioner argues, the SEC justifies the proposed derivatives framework as an “exemption” from Section 18 of the Investment Company Act (“Capital Structure of Investment Companies”), even though the SEC is in fact limiting behavior that it has previously sanctioned. It is not at all obvious that the conduct requires an exemption from Section 18; and the fact that the SEC had previously sanctioned the conduct would seem to indicate that no such exemption is required. If no exemption is required, it raises the question of the specific authority under which the SEC proposes to act.

The proposal also raises the question of whether the SEC acted appropriately in further restricting the activities of SEC-registered investment companies that have made appropriate disclosure of the risks involved in their investment strategies. The safety that SEC-registered investment companies provide to investors necessarily comes at a cost, whether it is the increased cost of managing the fund or the implicit cost to investors being denied investment opportunities. It is far from obvious that the subsequent costs that the SEC proposes here are justifiable.

As for the risk of derivatives, the idea that such risk may be judged based on a predetermined notional “size” measure is inherently inexact. Beyond that, the requirement of specified derivatives management procedures has the feel of more government-required formalities that have the potential to provide more benefits to consultants than to investors.